Because Mainstream Personal Finance Advice Is Not What It Should Be

Yesterday former Merrill broker and municipal bond investor Suze Orman, CFP, sent out word to her legions of followers that they should "be extra careful in how you invest at this point in time." The Oracle of Berkeley continued:

A pullback from here shouldn’t be surprising given the fast and steep rise. Meanwhile there’s the evolving concern that Greece’s debt problems could spread to other countries given the inter-connectedness of all our economies. Add it all up and there’s more to worry about than cheer.

I am writing down the date she wrote this "2-8-10" and that day’s S&P close "1056.74" on a post-it I am placing on the wall here at BMA World Headquarters. I would encourage my legion of followers to do the same, so that together we can bask in the wisdom and foresight of the Great Suze.

Orman goes so far as to recommend that investors act on her vision through dollar cost averaging. That’s more than a little asinine, but before discussing it, let me dwell a bit on her reasons for worry. It’s not every day that Suze shares her market timing insights. (In fact, I think this may be the first time ever.)

Greece is certainly a real issue. But it is hardly a storm cloud on the horizon. It is already here raining on us. And it could be the sky is starting to clear. The same day Suze’s pronouncement was issued, the news broke that the other EU members were grudgingly working on a plan to bail Greece out, which is pretty much what everybody was expecting would happen all along.

Personally, I think the importance of Greece in the recent market swoon is a bit exaggerated. The markets are worried about a country with out of control government deficits, but it’s not Greece.

And Orman’s statement that "A pullback from here shouldn’t be surprising given the fast and steep rise" is a bit odd. The S&P went up a miraculous 57.5% in the seven months from March 9th, 2009. (If you haven’t lately, read the post I wrote that day saying the market was crazy cheap.) But since then, in the four months since October 8, 2009, the market has been roughly flat. So why expect a pullback now?

The problem with Suze’s prognostications is not that they are half-baked conventional wisdom, but that they are stale half-baked conventional wisdom.

So on to dollar cost averaging. DCA is the Monty Hall Problem of personal finance. You either quickly see why it makes no sense or no amount of reasoned argument will persuade you to give it up. The basic idea is that instead of investing all your money in one go, you dribble it out over time and so wind up with a buy-in price that is the average price over a longer period rather than the single price you would get today.

DCA has a lot of emotional appeal, for reasons explained rather well by Ken French in this video. From a non-emotional and rational point of view, it almost, but not quite, makes sense. The averaging of prices over time is not really diversifying in the usual meaning of the term. The returns on each individual purchase are perfectly correlated. All you are doing is swapping today’s price for the average price over some time period.

To see why there is generally no reason to prefer the average price, consider the choice between three prices: today’s price, the price in a year, and the average price over the course of the next year. Assuming you want to buy a stock, which price do you choose? That depends. Do you think the stock is going to go up in the next year? Then today’s price is most likely to be the lowest. If you think the stock is going down, then the price a year from now makes most sense. The average price would only be best if you expected the stock to go down and then up during the year. (Don’t confuse this with volatility: average would be a disastrous choice if it went up then down.)

I wrote about DCA last fall. I gave as an illustrative example a case where a person had $12,000 to invest and was considering putting it all in the market at once or making 12 $1,000 monthly investments. Several commenters on that post objected that this was a pointlessly unlikely scenario.

In a coincidence that approaches creepy, Suze writes

For those of you who are about to do an IRA ROLLOVER or a ROTH Conversion and you are all in cash, I would not take that entire amount of cash and invest it all at once. I would absolutely divide that money up by dividing it by 12 and invest that amount month in and month out using the Dollar Coast Averaging technique I talked about above. So if you are rolling over $12,000 I would divide $12,000 by 12 which is $1000 and invest $1000 every month or if that is too much for you divide $12,000 by 4 which is $3000 and invest every four months. [Can't this woman hire a copy editor? Honorable mention to the best explanation in the comments of what dollar coast averaging might be.]

So not only does Suze advocate the use of smoke-and-mirrors DCA, she apparently believes that IRA rollovers and Roth conversions involve going to all cash. And that it would make sense to do something differently with your investments if you were in the midst of a rollover or conversion than if the accounts were just sitting there.

No Comments

Much as I always enjoy a good snigger at The Sooze, I can’t say I understand your attack on DCA. Of course if knew the future direction of a stock, a fund, or the market as a whole I would buy low. And within my IRA, I can rebalance the existing portfolio to put more into stocks when the market is down, within my target allocation.

But of course no one knows the future (who expected the market surge following March 2009?) and therefore market timing makes no sense. It does make sense to me at least to keep contributing my 10% or whatever from my paycheck each two weeks knowing that I am buying additional shares in my funds, whether the price is low or high any given payday.

Its not really dollar cost averaging when you buy every paycheck, that’s just buying as soon as you get paid and have the money to buy (saving regularly).

Truly DCA would be taking a lump sum of money and buying over time rather than all at once.

And I think Frank’s point is that if the markets are going up over time, you’re best to buy TODAY rather than pay the average cost over time because now is generally lower than the average cost over from now to a year from now.

I live in Canada and we have the TFSA (similar to a Roth) come into being last year, which allows you to save $5k / year. I had 10k and change from an ING account (2 years +interest) so I decided to buy mutual funds instead of the savings account. I lumped it in the first day I got, and am down 3% or so. If I had bought a week later, I’d be up 1% or so. If I had DCA’d over a month or a year, I may be in better shape. Will it make a difference over 25 years? Probably not.

@adam, thanks for the clarification… I was going to say something similar

I do a combination of DCA and market timing… my wife has a 401K, and in each paycheck a percentage goes into a mix of bonds and stocks. It rebalances every 3 months. As you said, this isn’t “real” DCA, it’s just regular savings.

In addition, we both have IRAs. For this, we try to do some clever timing… wait for a market correction, and then jump in with one lump sum.

I don’t know much about Greece’s affect on the economy. I am a believer in DCA. It is proven to keep emotions out of investing. It can also keep a healthy balance in investing (finding middle ground instead of highs and lows).

January 2001: Suze Orman, financial guru. “In the low 60s here, I think the QQQ, they’re a buy. They may go down, but if you dollar-cost average, where you put money every single month into them, I think, in the long run, it’s the way to play the Nasdaq.” (Fact: You lose, the QQQ lost 60% more by Oct 02)

Investing a set amount of money every 2 weeks through your 401k is absolutely DCA. It doesn’t matter if you have a lump sum up front or not. You are still averaging the cost of your investment over a period of time.

As Ken stated, it removes the emotion from investing. I think for long term investors, it works.

I agree with Frank (and disagree with many others) that investing a portion of each paycheck isn’t really dollar cost averaging. DCA is a strategy that is meant to alleviate volatility risk by trickling money into a vehicle over time, rather than buying in all at once. But to be a strategy, DCA has to be a _choice_; you can’t choose to invest a portion of your next 1,280 paychecks today. (And I would if I could!) At least not at my company.

Given a big pile of cash–and if you have one of these, it’s because you panicked at the bottom of the market, isn’t it?–you control risk best by doing the things you ought to have been doing all along: setting up a good asset allocation and buying low-cost, low-fee investments that seem a little boring when you talk about them over cocktails. Say, half in a Vanguard bond fund and half in their total stock market fund (being conservative on the assumption that the pile of cash does represent a panic sell).

William Bernstein’s _The Investor’s Manifesto_ is especially recommended–certainly moreso than anything by Orman.

However, DCA does NOT give the average price. With DCA, you will always end up with a price that is better than the average price.

By buying a set dollar amount, you buy more shares when the price is low, and less shares when the price is high. Technically speaking, this means you get the harmonic mean, which is always lower than the simple (or arithmetic) mean.

@Parker Bohn: I used to think that, too. The error is you bank non-invested money in risk-free investment. However, the very existence of a risk-free rate implies you make the same amount of money on average, whether you take the risk-free or the equivalent risky investment.

You are referring to the harmonic versus the arithmetic mean, or in a more fancy setting Jensen’s inequality. You do own a larger number shares at the end if you buy early (on average). Your expected net worth is the same. This is no contradiction because the number of shares you get and the stock price are not stochastically independent.

Finally, government bonds or their money market equivalent yield less the stock market on average. The difference is called risk premium. So what you would take as replacement investment for a hypothetical risk-free rate would on average make less than the stock market.

Jim, I don’t blame Suze for doing what she does with her money either, and yes someone with 25mil doesn’t need to take risks to live a comfortable lifestyle v someone with negative net worth saving $500/month in a pension.

But she still advised quite clearly to buy QQQ to her masses, and people who did that would have lost big time. People who couldn’t afford to lose. Meanwhile, she sits cozy on her bonds, and despite saying she bought some QQQ in that article, the vast vast vast vast majority of her portfolio remained in extremely secure tax free municiple bonds.

I just don’t think she should be dishing out market timing advice to anyone. Whether on QQQ or on PIIGs.

Adam, Yeah I am not saying I’d trust Orman for stock advice. But buying muni’s herself while giving stock advice doesn’t make her a hypocrite nor does that fact alone make her stock advice bad.

You point out the advice to buy QQQ as bad advice. Its easy to cherry pick bad people gave in 1999-2001 in hindsight. That article you link to is full of such examples of what turned out to be ‘bad’ advice in hindsight from a who’s who of well known financial advice givers. Warren Buffet recommended buying index funds in the past, someone could take that and cite it as evidence you shouldn’t trust Buffet for stock advice.

Parker Bohn: I have now made the same mistake with sloppy terminology both times I have talked about DCA. Shame on me. As I said last time:

You are correct, DCA doesn’t give you the average per-share price, for the reasons you explain. It will, however, give you the average return over the period from each investment date to the end, i.e. the average of January to December, February to December, March to December, etc.. I was sloppy with my terms, sorry. But I hope we can agree that it is returns we really care about.

What DCA boils down to is that you will beat the up-front investor if the market declines during your investing period, and you will lose to the up-front investor if the market rises. Every example of DCA ever created shows exactly this and nothing more. I looked at the Mike Piper example linked above, and, although the graph had some fancy footwork, it showed an average purchase price lower than the initial price. So the DCA investor wins. Hooray!

But you have to think about this for a minute. Do we invest in assets that historically go up or down? The arc of the stock market is long, but it bends towards increase. That is why we buy stocks. And if the investment appreciates in value over time, the DCA investor will lose to the up-front purchaser, every single time.

So “DCA” in the form of paycheck deductions is a terrible buy over a 30- to 40- year working lifetime…at least, it is unless we’ve all made a horrid mistake about the nature of the stock market, in which case we should all be in bonds anyway. True DCA, in which a pre-existing lump sum is trickled into the market over time, is only good to the extent that the investment itself was poor.

It’s not even very appealing as a hedge against volatility, since it sacrifices upside to protect the downside (and doesn’t protect the downside perfectly–you still lose money if the investment declines in value).

The reason people like DCA is the emotional one that they are loss averse. They’d rather do closer to averagely well, then risk doing very badly.

If 97 times out of 100 you’d do better investing a lump sum in one go than dollar cost averaging, it may still be rational taking into account this emotional viewpoint to go for the DCA approach, especially if 1/100 times you lose half your money.

Still, always great to hear robust complaints about sacred cows!

Re: Greece, the market stopped reacting almost exactly as the problem finally hit the mainstream news. Onecan quibble about the efficiency of the markets, but for it to take couple of weeks to be hit by Suze’s revolations would be downright comatose.

That said, I’ll defend her in terms of past pronouncements. Anyone who says anything about the market will be wrong much of the time – when not if.

Of course, Mike would say (rightly, perhaps) that’s why they should keep schtum!

You Americans have never heard of Dollar Coast Averaging!!?? Allow me to enlighten you (and possibly provide you with your own form of entertainment).

This is a Canadian term to describe one of the statistics in a local form of gambling; Looney racing, where you race your Looney down small hills with other loonies, and the winner takes all. Dollar Coast Averaging is the sum of all your time scores divided by the number of races you’ve participated in.

Of course dollar cost averaging assumes that the price will bounce back, which for many individual stocks it never does. But you know if the market does fall from here it will only solidify Suze’s fanbase

“I agree with Frank (and disagree with many others) that investing a portion of each paycheck isn’t really dollar cost averaging. DCA is a strategy that is meant to alleviate volatility risk by trickling money into a vehicle over time, rather than buying in all at once. But to be a strategy, DCA has to be a _choice_; you can’t choose to invest a portion of your next 1,280 paychecks today.”

I find that comment to be ludicrous.

If I have $12,000 in my hand and spend $1,000 a month, or I spend $1000 a month, the price I pay for the stock is the same. The money I make or lose – ON THE STOCK – will be the same.

The only difference is that, presumably, I’m earning interest on the unspent money in hand.

Disclaimer

All advice in this blog is guaranteed to be worth at least what you paid for it, or double your money back. All persons dealing with matters of personal finance are advised to gather information from blogs, books, radio and TV, consult with professionals, discuss the matter with anybody who will listen, and then make their own decision. Because it’s their money.